In the world of business valuation, market multiples play a crucial role in determining the worth of a company. Whatever the reason for the business valuation engagement (e.g., buying, selling, investing in a business, settling an estate, shareholder buyout, etc.), understanding market multiples is essential for making informed decisions. In this blog, I will explain what market multiples are, how they are calculated, and how they're used in business valuation.
What Are Market Multiples?
Market multiples, also known as valuation multiples or comparables, are ratios that compare a company's value to its financial metrics. These metrics typically include revenue, earnings, cash flow, or other relevant indicators. Earnings metrics can be Earnings Before Tax (EBT), Earnings Before Interest and Tax (EBIT), or Earnings Before Interest, Tax, Depreciation, and Amortization (EBITDA). Market multiples provide a quick and straightforward way to gauge a company's value relative to its peers or the overall market.
How Are Market Multiples Calculated?
Market multiples are derived from transactions of similar companies in the market. These transactions can include mergers and acquisitions, public stock offerings, or private company sales. To calculate a market multiple, you divide the company's value (such as its market capitalization or enterprise value) by the chosen financial metric (such as revenue or earnings).
For example, if a company's market capitalization is $100 million and its annual revenue is $50 million, the market multiple based on revenue would be 5x ($100MM / $20MM). Similarly, if the company's enterprise value is $150 million and its annual earnings before interest, taxes, depreciation, and amortization (EBITDA) are $30 million, the market multiple based on EBITDA would be 5x ($150MM / $30MM).
For smaller companies not publicly traded, the revenue metric would be determined by taking the price at which the company sold and dividing it by its net revenue. If the business sold at $750,000 and the revenue was $1.5 million then the revenue metric would be 50% or 0.5x ($750K / $1.5MM).
Types of Market Multiples
There are several types of market multiples commonly used in business valuation:
Price-to-Earnings (P/E) Ratio: This ratio compares a company's stock price to its earnings per share (EPS). It indicates how much investors are willing to pay for each dollar of earnings generated by the company.
Enterprise Value-to-Revenue (EV/Revenue) Ratio: This ratio compares a company's enterprise value (market capitalization plus debt minus cash) to its revenue. It measures the company's value relative to its sales.
Enterprise Value-to-EBITDA (EV/EBITDA) Ratio: This ratio compares a company's enterprise value to its earnings before interest, taxes, depreciation, and amortization (EBITDA). It provides a measure of the company's value relative to its operating performance.
Price-to-Book (P/B) Ratio: This ratio compares a company's stock price to its book value per share. It indicates how much investors are willing to pay for each dollar of the company's net assets.
Price-to-Revenue Ratio: This ratio compares a company’s asset sale-based price to its net revenue. This ratio is commonly used in small business valuations.
Price-to-SDE Ratio: This ratio compares a company’s asset sale-based price to its net Seller’s Discretionary Earnings (SDE). SDE is defined as net earnings before tax (EBT), plus one owner’s salary, plus interest expense, plus depreciation. This ratio is also commonly used in small business valuations.
Price-to-EBIT Ratio: This ratio compares the company’s asset sale-based price to its earnings before interest and tax (EBIT). This ratio is commonly used in small business valuations as a sanity check or industry rule of thumb.
How Are Market Multiples Used in Business Valuation?
Market multiples are used in conjunction with other valuation methods to assess a company's worth. Here is how they are typically used:
Comparable Company Analysis (CCA): In CCA, analysts identify comparable companies in the same industry and calculate their market multiples. They then apply these multiples to the financial metrics of the company being valued to estimate its value.
Market Transaction Comparables Analysis: Similar to CCA, transaction comparables analysis involves identifying recent transactions in the market involving similar companies. Analysts run a correlation of the transaction data to see if the multiple for that metric has a high correlation and the data can be used. Analysts use the multiples from these transactions to estimate the value of the company being valued.
Benchmarking: Market multiples serve as benchmarks for evaluating a company's performance relative to its peers. A company with higher multiples may be considered overvalued, while a company with lower multiples may be considered undervalued.
Sanity Check: Market multiples provide a sanity check when using other valuation methods. If the valuation derived from discounted cash flow (DCF) analysis or other methods is significantly different from the valuation based on market multiples, analysts may reevaluate their assumptions.
Limitations of Market Multiples
While market multiples are valuable tools in business valuation, they also have limitations:
Lack of Comparable Companies: It can be challenging to find truly comparable companies, especially for businesses operating in niche industries or with unique business models. There may be very few companies traded within a specific SIC or NAICS coded industry.
Volatility: Market multiples can be highly volatile, especially during periods of market uncertainty or rapid changes in industry dynamics.
One-Dimensional View: Market multiples provide a simplified view of a company's value and may not capture all relevant factors affecting its worth; especially company specific risk.
Non-Financial Considerations: Market multiples focus solely on financial metrics and may overlook non-financial factors that can impact a company's value, such as management quality, brand strength, or market positioning.
Market multiples are powerful tools in business valuation, providing quick insights into a company's worth relative to its peers or the overall market. By understanding how market multiples are calculated and used, investors, entrepreneurs, and financial professionals can make more informed decisions regarding a business valuation. However, it is essential to recognize the limitations of market multiples and use them in conjunction with other valuation methods for a comprehensive assessment of a company's value.